The Genius of the Price System

The Daily Reckoning

Jan. 3, 2012, 2:52 PM

The other day, a local hamburger joint was advertising a 99 cent hamburger, and I took the offer. It was great. I wondered how they can make money this way. A few days later, my head still swimming with memories of that great experience, I went back. This time, I dug in a bit deeper and upgraded the order, including fries and a drink, and this time shelling out for my passenger too. The total bill came to $16. Wow. That's how they make money!

This was an interesting case of how a company uses a loss leader to draw you in and then makes up the difference on the upgrade. Of course, I could have stuck with the low-priced burger, but I did not. I behaved exactly as the burger joint hoped I would. This is dazzling in so many ways. They know me better than I know myself. And good for them.

To be sure, some cynical people would regard this as a rip-off. I don't see it this way. I didn't have to return to the drive-through window, didn't have to upgrade my preferences, didn't have to buy for the person next to me, didn't have to order fries and a drink. These were all decisions that I made on my own. Nor do I regret them: The food was better than ever. I'm free to refuse to go back, but I will go back.

A wise man once told me that in this life, you can obey balance sheets or bullies. In the end, those are the only two paths. He was drawing attention to an unavoidable reality in a world of scarcity. All scarce things must be allocated among competing ends. This can be done top down by people in control, or it can be accomplished bottom up with the signaling system that emerges from voluntary exchange. The two approaches don't mix well.

Of course, prices do not exist apart from human will. They can be played with, but not finally controlled, by producers in the market. There are vast surprises along the way. It's not the case that only the rich thrive in this environment. Who would have thought that the sci-fi machine in old movies that provides instant answers to all questions would eventually be provided for free by one of the world's biggest companies? I'm speaking here of Google, but the same good could be said of the many alternative search engines out there.

Who would have thought that the world's largest communication networks — email and social networking — would be free also, funded mostly by selling ad space and upgraded products? In the same way, most of the world's most-useful software is free, as is the cloud-based word processing system I'm using to type this article. So too for the music that filled my living room for 12 straight hours yesterday, all selections from the 16th and 17th centuries, all provided to me for free. Amazing.

The price system is a constantly changing kaleidoscope that beautifully merges our subjective imaginations with the gritty realities of the physical world. It is the combination of mind and matter that yields an output — a simple number — that never lies. It gives us that glorious balance sheet that tells you whether you are doing sustainable or unsustainable things. No institution can compete with its efficiency, much less displace its indispensable utility in this world.

I once heard of a man's mother who had an obsession with gas prices. Everywhere she would go, she would look at the price signs and announce to one and all what they said. "Hmmm, they are charging $3.15." "There's one charging $3.45." "That place is charging $3.10." "They have gas for $3.50." So it would go for the entire trip. She had no opinion on any of these prices; she just found it interesting to observe and compare. And perhaps her observations reflected a kind of confusion about how the same thing offered in different places could be priced in such different ways.

It is, indeed, intriguing. There are two things we can know for sure. First, the producer — the retailer, in this case — would like to charge more for a gallon of gas, even a million dollars. Second, the consumer would like to pay less for a gallon of gas, even zero dollars. The final price represents a point of agreement. It is arrived at even though the parties to the exchange did not speak in advance; a single number embeds billions of bits of data about human values, resource availability and alternative uses of money and resources.

And it all happens without a central planner — or even so much as a central board of experts — telling us what the prices should be. This is genius at work.

Who could have even a year ago predicted that physical books would sometimes sell for less than digital books of the same title? This defies every expectation. The physical good is a real thing that you can hold and costs money to make (so much for the labor theory of value). The digital goods need only be made once and then can be sold billions of times. So what is the trick? It comes down to consumer demand. We really like ebooks — their convenience and speed of delivery — and are willing to pay for them.

The price system also decides which companies are profitable and which are not. It has nothing to do with the size of the company. If you take in less than you spend, you will eventually go belly up. If you take in more than you spend, you will grow. The vast global network of price formation ultimately reduces to this simple calculation that determines how all the world's resources are used. Every company faces the same constraint. So whether or not these pricing decisions are rational has much to do with the fate of the world.

The point is that it is impossible to predict these things. No matter how smart the team of experts, how powerful and prestigious the price setters behind the curtain, there will always be surprises out there. That's because no one can fully predict the values manufactured by the human mind nor know enough about the world to foresee every possible alternative use of a resource that goes into the production process. When economists say that something should be "left to the market," they are really saying that people should be left to work all this out for themselves. This is the only way of dealing with all the uncertainties of this world.

These are some of the insights about the price system that can be drawn from the works of Carl Menger, Ludwig von Mises and F.A. Hayek. They understood that there is no substitute for the price system. And this is why it is also so enormously dangerous for any society to give power to a central bank to manipulate the price system from the top down. Its decisions about the money supply can't help but be irrational and ultimately destructive to economies and the realization of the common good.

The same could be said of a range of state institutions that distort prices, such as wage floors and ceilings, subsidies and penalties for particular companies and taxes and regulations that extract resources and profoundly affect the profit-and-loss calculation. They all interfere with the fluid functioning of the price system. They all waste resources. They all interfere with the efficiency of the market.

More and more, people of the developed world are seeing the balance sheet replaced by the bully. This is harming both our prosperity and our personal liberty to make decisions for ourselves. If the bully can tell the fast-food joint what its prices ought to be, the same bully can tell me what I can and cannot eat, what and where I can and cannot drive and where I can and cannot work and under what terms.

The price system, premised on the idea of private property and the freedom to choose, is the best friend liberty and prosperity ever had. The next time someone complains about it, ask that person what he would prefer to take its place.